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Fundamental Valuations and the Divide over Market Distortion

The aging population, cash on corporate balance sheets and changing macroeconomic conditions play into how assets get priced.

There is vigorous debate in the investment community between those who focus on historical patterns and the concept of financial market mean reversion and those who believe present economic conditions defy precedent. The former tend to warn about excessive valuations in several risk asset classes, whereas the latter focus more on extraordinary monetary accommodation and how that may mitigate this dynamic. This discourse has brought up and illuminated many key points. But at the same time some critical themes are being overlooked. Specifically, in addition to monetary policy, asset class valuations must be understood in the context of factors that affect the financial markets, such as structural demographic change, an evolution of corporate liquidity and an unprecedented capital structure.

Alongside continued policy accommodation, these market characteristics will largely drive asset prices in the year ahead, even as QE unwinds and interest rates begin to normalize. Indeed, when examining and selecting investments, their fundamental relative valuation is still a key consideration.

As a case in point, we are witnessing a monumental shift in global population dynamics as advances in public health and standards of living have allowed for a dramatic rise in average life spans. In fact, globally, average life expectancy has extended by 50 percent since 1950 and 30 percent since 1980. Moreover, in the U.S. these longer life spans coincide with the impending retirement of the baby boomers. With 1 million additional people a year, the over-65 demographic is the fastest-growing age segment in the U.S., according to Credit Suisse research. 

The consequent need for income generation in retirement, as well as modest net supply in fixed-income markets, is likely to translate into strong and increasing demand for yield during the next few years. It will also keep interest rates below long-run historical averages. The answer to this demand would derive both from more traditional sources, such as pension funds, insurance companies and individual investors, as well as newer market players, such as sovereign wealth funds. Yet, regardless of the source of demand, the net effect should be to lower the required discount rate applied to investment cash flows, particularly in assets that have a high probability of delivering that income stream. Thus a demographically derived structural bid for yield, combined with policy accommodation and an evolving corporate capital structure, significantly changes the calculus of investment value today in a way that simply isn’t captured by many mean reversion frameworks.

Moreover, in the wake of the 2008–’09 financial crisis, many corporations have become more cautious in managing their capital structures, with a great deal of corporate debt issuance being refinanced at historically low interest rate levels and maturities extended. Additionally, many corporations have raised cash levels. Whether this is from a desire to reduce potential risk or because of economic uncertainty is not clear, but the cash on hand as a percentage of market cap for the largest 25 corporations in the S&P 500 index has jumped from 2 percent in 1999 to 10 percent in 2014. According to recent Bloomberg data over roughly the same period, the average net debt-to-equity ratio for the index as a whole has dropped from 70 to 42 percent. The average cost of that debt has declined from 7.3 to 3.1 percent — a remarkable tailwind for the corporate sector, which could expand returns on equity, in our view, if it were to releverage.

Where does this leave us in terms of asset class valuation? From the all-important perspective of interest rates, we at BlackRock think rate levels have begun a long process of normalization away from their recent extraordinarily low levels, but this process will take time. Rate levels will remain below their historical averages for years to come. To take the long end of the yield curve as an example, at 3.58 percent, the yield on 30-year U.S. Treasury bonds is well below its 30-year average of 6.28 percent. Although we are not likely to see a convergence to that average anytime soon, it would not surprise us to see the long bond somewhere between 4 and 4.5 percent in the coming year. Still, the U.S. Federal Reserve will work hard to keep a lid on rates — as long as inflation remains benign — since low rates are vital for sustaining recovery in the housing markets.

In the end, we will continue to see a tremendous bid for yielding assets, and activist investors will continue to agitate for further share buybacks and dividend increases as they attempt to extract the capital on corporate balance sheets (see chart). As policy evolves, we will see a return to higher degrees of market volatility. We do not foresee the dramatic market declines in risk assets that some in the mean reversion camp predict. The next period will indeed be one of greater volatility — one in which investors should focus on relative value alongside financial conditions in seeking gains.

Rick Rieder, managing director, is chief investment officer of fundamental fixed income and co-head of Americas fixed income for BlackRock

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